5/04/2009 @ 1:00PM

Two Cheers For The Stress Tests

Within the first month of the Obama administration, a nervous Timothy Geithner announced the Treasury’s four-part Financial Stability Plan to shore up American banks and capital markets.

The plan contained the first appearance of a “stress test” for the 19 largest banks. The other parts involved ambitious public-private investment funds to purchase asset-backed securities in the market, as well as a smaller effort to stem mortgage foreclosures. The plan addressed all of the most troubled spots affecting financial stability and attempted to minimize the amount of taxpayer funds required for its execution. But it was widely regarded as a disappointment, and the Dow Jones dropped 380 points after Geithner’s announcement.

The market was unhappy, many said at the time, because of the lack of details. But what really seemed to be bothering everyone was the uncertain future of our largest banks, which had already written off more than $1 trillion of bad loans (with more to come), been forced to take on billions of TARP money as new capital and whose stock prices had been pounded into single digits.

Many thought the only remedy was to “nationalize” the banks, which would involve several trillions of new government guarantees, turn the banks into helpless zombies such as
AIG
or FNMA and leave the government to the unwanted role of managing banks, something no government had ever done effectively.

Alternatively, troubled banks could be “seized,” as at WaMu and IndyMac, with depositors protected but all other liability holders thrown into bankruptcy court. For big banks–which the government had promised to keep from failing–such an outcome would surely make the financial chaos and panic following
Lehman Brothers’
unexpected bankruptcy look like kid stuff.

Geithner’s dilemma was how to avoid both of these alternatives while still bringing about financial stability and fair treatment for those involved–a difficult, needle-threading task in the best of times–not to mention staying sensitive to financial issues that were then dominating the news in Washington and New York.

To work, the stress test idea had to (a) zero in on the banks most likely to be “too-big-to-fail,” (b) ensure a process in which the government was fully in control, not the banks themselves, or their lobbyists and political supporters, (c) be a useful and realistic test upon which meaningful decisions about the future of individual banks can be made and (d) be reassuring to the markets and the public (not risking another descent into the cataclysmic market conditions of September to December 2008).

It also had to provide for a battery of government programs and facilities to backstop the banks’ ability to fund and refund their liabilities while all of this is going on. The Federal Reserve, in particular, has been very proactive at doing this and keeping money markets functioning normally.

The idea of stress-testing is to make sure banks have enough capital–and common equity capital specifically–to make it through a storm that promises to be even worse than the one we already have. To be effective, however, a stress test must consider market values of assets, off-balance sheet obligations and the need to increase reserves for losses to account for worsening economic conditions.

One widely quoted guesstimate is that the combined stress tests will show that U.S. banks may have to add over $1 trillion in capital to their balance sheets before all is said and done.

How a bank does on its stress test is supposed to lead to a polite “conversation” between its management, its board of directors, the Fed, the Treasury and the FDIC about what to do next. Supposedly, there is no way to “flunk” a stress test. But the results are very likely to impose a differentiation between banks that are well capitalized (and may be allowed to repay their TARP money), those that are adequately capitalized (and do not need additional capital beyond retained earnings) and those that will need additional capital.

The plan provides a leisurely six months for those needing more capital to attempt to raise it from the markets (as many European banks, including some in distress, have managed to do through shareholder rights offerings) before they are forced to return to the now-dreaded TARP. A further visit there is likely to involve government control, management and board changes and a break-up of the business. But at least we will know where we stand.

Shares are already trading at prices that reflect the expectation of their bank’s classification later this week when the test results are released. Several, like
Citigroup
and
Bank of America
, are trading at tiny fractions of their book value, suggesting that most of the damage to common stockholders of the banks caught up in this situation has already been realized.

Depositors are content. Other liability holders seem relaxed and willing to roll over the paper they hold. Banks continue to function, and they are attempting to cooperate with the government to deal with mortgage foreclosures and increase commercial lending. All seems fairly cool.

Meanwhile, the biggest banks are appealing or arguing over their particular stress test results and the remedies that will be required. But it has been a successful effort so far, worthy of two cheers–but the third one will depend on how it all goes from here, especially how those deemed to need more capital actually obtain it.